Corporate Finance and Risk Management
STRATEGIC LEVEL
June 2022
Samira Anthony
Sources of Long Term Financing
Loans,
Bonds,
Debentures,
Leasing
DEBT FINANCING
IPOs,
Private Placements,
Right Issues,
Share Repurchase,
Employee Share Ownership Schemes
EQUITY FINANCING
Bank loans
Term loans
Banks often provide term loans as medium- or long-term financing for customers. The customer borrows a fixed
amount and pays it back with interest over a period or at the end of it. You will hopefully remember that this
contrasts with an overdraft facility, when a customer, through its current account, can borrow money on a shortterm basis up to a certain amount. Overdrafts are repayable on demand.
The advantages of a term loan are as follows.
(a) They are easy and quick to negotiate and arrange
(b) Flexible repayment schedules may be offered by banks
(c) They are particularly useful for small entities who can have problems raising capital
Mezzanine finance
This is unsecured loans that rank after secured debt but ahead of equity in a liquidation. It is commonly used for
management buy-outs, where there is a need to bridge the gap between the amount of loans that banks are
prepared to make and the amount of equity funding available.
It is higher risk lending than bank loans so tends to attract a higher rate of interest.
Creditworthiness
From the lender's viewpoint, the interest rate charged on loan finance will normally reflect the risk associated with
the loan, and an assessment of a company's creditworthiness will be made.
Long-term debt
Bonds
The term bonds describes various forms of long-term debt a company may issue. The parameters of bonds and
their valuation was discussed in Chapter 4. This section looks at other practical issues relating to their issue.
Bonds come in various forms, including:
Redeemable
Irredeemable
Floating rate
Zero coupon
Convertible
Debentures
A debenture is a written acknowledgement of a debt by a company, usually given under its seal and normally
containing provisions as to payment of interest and the terms of repayment of principal. A bond may be secured
on some or all of the assets of the company or its subsidiaries.
Debentures are defined as the written acknowledgement of a debt incurred by a company, normally containing
provisions about the payment of interest and the eventual repayment of capital. The terms of the bond are set out
in a trust deed
Security
Bonds will often be secured. Security may take the form of either a fixed charge or a floating charge.
(a) Fixed charge
Security would be related to a specific asset or group of assets, typically land and buildings. The company
would be unable to dispose of the asset without providing a substitute asset for security, or without the lender's
consent.
(b) Floating charge
With a floating charge on certain assets of the company (for example inventory or receivables), the lender's
security in the event of a default of payment is whatever assets of the appropriate class the company then owns
(provided that another lender does not have a prior charge on the assets).
The company would be able, however, to dispose of its assets as it chose until a default took place. In the event of
default, the lender would probably appoint a receiver to run the company rather than lay claim to a particular
asset.
Securitisation
refers to the bundling together of financial assets into another financial instrument, often to increase liquidity. For
example, banks securitise mortgages (receivables for the bank) and sell them on to increase their liquidity
mortgages pay a return over a long period, whereas selling the securitized mortgages provides close to instant
liquidity.
Commercial paper
refers to short term 'IOUs' issued by large, well-established businesses, often to finance working capital needs in
the short term. They do not reward the lender with a rate of interest, but are issued at a discount to face value.
For example, a Rs. 100 commercial note may be issued for Rs. 95, and repaid at face value in 6 weeks' time. They
are usually unsecured, hence only practical for large, well-known businesses that investors have a high level of
confidence in.
Convertible securities
Convertible bonds
Convertible debt is a liability that gives the holder the right to convert into another instrument, normally
ordinary shares, at a pre-determined price/rate and time.
The conversion value and the conversion premium
The current market value of ordinary shares into which a unit of bonds may be converted is known as the conversion
value. The conversion value will be below the value of the bonds at the date of issue, but will be expected to increase
as the date for conversion approaches, on the assumption that a company's shares ought to increase in market value
over time.
The issue price and the market price of convertible bonds
A company will aim to issue bonds with the greatest possible conversion premium as this will mean that, for the
amount of capital raised, it will, on conversion, have to issue the lowest number of new ordinary shares. The premium
that will be accepted by potential investors will depend on the company's growth potential and the prospects for a
sizeable increase in the share price.
Convertible bonds issued at par normally have a lower coupon rate of interest than straight debt. This lower yield is
the price the investor has to pay for the conversion rights. It is, of course, also one of the reasons why the issue of
convertible bonds is attractive to a company, particularly one with tight cash flows around the time of issue, but an
easier situation when the notes are due to be converted.
When convertible bonds are traded on a stock market, their minimum market price or floor value will be the price of
straight bonds with the same coupon rate of interest. If the market value falls to this minimum, it follows that the market
attaches no value to the conversion rights.
The actual market price of convertible bonds will depend on:
The price of straight debt
The current conversion value
The length of time before conversion may take place
The market's expectation as to future equity returns and the risk associated with these returns
Example: Convertible bonds
CD has issued 50,000 units of convertible bonds, each with a nominal value of Rs. 100 and a coupon rate of interest
of 10% payable yearly. Each Rs. 100 of convertible bonds may be converted into 40 ordinary shares of CD in three
time. Any bonds not converted will be redeemed at 110 (that is, at Rs. 110 per Rs. 100 nominal value of
bond).
Estimate the likely current market price for Rs. 100 of the bonds, if investors in the bonds now require a pre-tax
return of only 8%, and the expected value of CD ordinary shares on the conversion day is:
(a) Rs. 2.50 per share
(b) Rs. 3.00 per share
Compute value of a bond under above each options .
Advantages of convertibles
(a) Convertibles serve as a sweetener for debt by allowing the investor to participate in increases in price of
share capital.
(b) The issuer can pay lower interest than on straight debt. This may be significant if funds are tight during
the early years of issue of the bonds. They are usually issued by high-growth companies who do not want
the burden of high interest payments.
(c) The attractions of the conversion rights, the possibility of a significant capital gain and the hedge against
risk (the right to have the debt repaid if conversion is not worthwhile), should mean the lender is willing to
accept fewer other conditions.
(d) Convertibles may provide a means of issuing equity ultimately at a higher price than current market price.
(e) There may be provisions in the issue terms allowing the issuer to force conversion if the market price of
the bonds is greater than the conversion price.
(f) If the company issued straight bonds initially and then issued equity to redeem the bonds, two lots of issue
costs would be paid, whereas with convertible debt, issue costs would only be paid once.
(g) The debt ratio is reduced if conversion takes place.
Disadvantages of convertibles
(a) If the company had waited for funds, and the market price increases significantly above the conversion
price, it would be better off issuing shares at a higher price, rather than having to issue shares at the lower
conversion terms.
(b) The company has to repay the debt if the share price does not increase.
(c) Some borrowers may be reluctant to invest because of the lower yield on convertible shares compared with
securities not having conversion rights.
International debt finance
Large companies with excellent credit ratings use the euromarkets to borrow in any foreign currency using
unregulated markets organised by merchant banks. This market is much bigger than the market for domestic
bonds.
International borrowing
Borrowing markets are becoming increasingly internationalised, particularly for larger companies. Companies are able to
borrow long-term funds on the eurocurrency (money) markets and on the markets for eurobonds. These markets are
collectively called 'euromarkets'. Large companies can also borrow on the syndicated loan market where a syndicate of
banks provides medium- tolong-term currency loans. The word 'euro' does not refer to the euro currency, it means any
currency other than the domestic currency (see below).
If a company is receiving income in a foreign currency or has a long-term investment overseas, it can try to limit the risk
of adverse exchange rate movements by matching. It can take out a long-term loan and use the foreign currency receipts
to repay the loan.
Eurocurrency markets
Eurocurrency is currency which is held by individuals and institutions outside the country of issue of that
currency.
Eurodollars are US dollars deposited with, or borrowed from, a bank outside the US.
A SL company might borrow money from a bank or from the investing public, in SL rupees. However, it might also
borrow in a foreign currency, especially if it trades abroad, or if it already has assets or liabilities abroad
denominated in a foreign currency. When a company borrows in a foreign currency, the loan is known as a
eurocurrency loan. (As with euro-equity, it is not only the euro that is involved, and so the 'euro-' prefix is a
misnomer.) Banks involved in the eurocurrency market are not subject to central bank reserve requirements
or regulations in respect of their involvement.
The eurocurrency markets involve the depositing of funds with a bank outside the country of the currency in which
the funds are denominated and re-lending these funds for a fairly short term, typically three months, normally at a
floating rate of interest.
Eurocredits are medium- to long-term international bank loans which may be arranged by individual banks or by
syndicates of banks. Syndication of loans increases the amounts available to hundreds of millions, while reducing the
exposure of individual banks.
Eurobonds
A eurobond is a bond sold outside the jurisdiction of the country in whose currency the bond is denominated.
How are eurobonds issued?
Step 1 A lead manager is appointed from a major merchant bank; the lead manager liaises with the credit rating
agencies and organises a credit rating of the eurobond.
Step 2 The lead manager organises an underwriting syndicate (of other merchant banks) who agree the
terms of the bond (eg interest rate, maturity date) and buy the bond.
Step 3 The underwriting syndicate then organise the sale of the bond; this normally involves placing the bond
with institutional investors.
Advantages of Eurobonds
(a) Eurobonds are 'bearer instruments', which means that the owner does not have to declare their identity.
(b) Interest is paid gross and this has meant that eurobonds have been used by investors to avoid tax.
(c) Eurobonds create a liability in a foreign currency to match against a foreign currency asset.
(d) They are often cheaper than a foreign currency bank loan because they can be sold on by the investor, who will
therefore accept a lower yield in return for this greater liquidity.
(e) They are also extremely flexible. Most eurobonds are fixed rate but they can be floating rate or linked to the
financial success of the company.
(f) They are typically issued by companies with excellent credit ratings and are normally unsecured, which makes
it easier for companies to raise debt finance in the future.
(g) Eurobond issues are not normally advertised because they are placed with institutional investors and this
reduces issue costs.
Disadvantages of Eurobonds
Like any form of debt finance, there will be issue costs to consider (approximately 2% of funds raised in the case
of eurobonds) and there may also be problems if gearing levels are too high.
A borrower contemplating a eurobond issue must consider the foreign exchange risk of a long-term foreign
currency loan. If the money is to be used to purchase assets which will earn revenue in a currency different to
that of the bond issue, the borrower will run the risk of exchange losses if the currency of the loan strengthens
against the currency of the revenues out of which the bond (and interest) must be repaid.
Note. Since eurobonds are a major source of finance, they may feature in exam questions. For example, you may
be required to compare euro bank loans and a euro-denominated eurobond, or to discuss the advantages and
disadvantages of different methods of funding, including a euro-denominated eurobond.